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FAREED ZAKARIA, HOST, GLOBAL PUBLIC SQUARE: Welcome to GPS, the GLOBAL PUBLIC SQUARE. I’m Fareed Zakaria. A few thoughts before we get started.

If you’ve ever wondered what a full-blown panic looks like, these past few weeks have been it. We’re not talking about economics anymore, but about deep psychology.

In the midst of this gloom, I remembered something Jeffrey Sachs, the noted economist, said to me a few months ago. He’s on the program again today.

Sachs has been arguing that this crisis has to force us to get our fiscal house back in order.

(BEGIN VIDEO CLIP)

JEFFREY SACHS, ECONOMIST: It’s time to grow up again and understand that we’re going to have to pay taxes – rich people first – and that from there, we’re going to have to use those revenues for the things that count: health, education, infrastructure, energy.

This is not an invitation to ignore our future. It’s an invitation to start thinking seriously about it again.

(END VIDEO CLIP)

ZAKARIA: It’s not just the federal government. Every household, every city, every county, every state in America has wanted things it was unwilling to pay for. And it made up the difference by borrowing in an era of cheap credit.

We wanted larger houses than we could afford, more TVs, more laptops – more of everything. And we did it all by racking up debt.

But the free lunch is over.

It’s not just for America. Look around the world. Britain, Spain, Ireland, other over-leveraged societies have all faced the same problem. We’ve run our companies, countries, households on principles that just didn’t make sense.

And we’ll have to change, and it will mean deep and wrenching pain, probably a tough recession. But in the end, it will make for a more robust American economy and a stronger global system. The house of cards is collapsing. But there is an opportunity here to build a house of bricks instead.

I’ll be right back with economist Jeff Sachs – and our main event, a conversation with George Soros.

(BREAK)

ZAKARIA: George Soros knows more than almost anybody about how markets operate, but he also has genuine insight into how the world operates.

Soros has been one of the most successful investors on the globe. His Quantum Fund, one of the original hedge funds, has an unequaled record of performance. And last year, at 77, he came out of retirement, made some massive bets, and by one account netted himself personally $2.9 billion.

I can’t think of anyone better suited to help us understand this crisis. George Soros, welcome.

GEORGE SOROS, CHAIRMAN, SOROS FUND MANAGEMENT: A pleasure.

ZAKARIA: Now that the government – the United States government, is guaranteeing almost every financial instrument in the country.

SOROS: Yes, yes.

ZAKARIA: It can’t do this indefinitely.

SOROS: So, you do need this kind of government guarantee. Without it, there would be utter collapse. Right? And this is generally now recognized, which means that the institutions that have this kind of insurance backing them up must be regulated.

ZAKARIA: Absolutely.

SOROS: And so, you need to improve regulations.

ZAKARIA: But can you keep these guarantees indefinitely? Do you foresee a future in which finance is going to be much, much more heavily regulated?

SOROS: Well, it certainly will be. And the slower we move, and the more reluctant we are to do the right things, the more money we’ll have to throw at it.

The one thing we have decided, that we are not going to allow the financial system to collapse. That’s what happened in the ’30s. We don’t want that again.

We have crossed the Rubicon. We have started throwing money at the system, and we will keep on throwing money. And this …

ZAKARIA: And eventually, do you think, because of that fundamental crossing of the Rubicon, eventually the government will win? By which I mean …

SOROS: Yes, I think eventually, because they do have infinite ability to print money. OK? But the damage will be greater, the cost will be greater.

The whole thing – this $700 billion plan – if it had been better constructed, if they had thought about it earlier, if they would deal with the housing situation, the damage would be less.

So, this government, because it doesn’t believe in government, is doing the wrong things. You need a government that believes in government. It also believes in markets and wants to give markets the best, the greatest opportunity, but is trying to govern well.

So you need better regulation, not more regulation.

ZAKARIA: What does this do to America’s balance sheet? I mean, the Fed is taking on these huge liabilities. The Treasury is going to spend all this money.

Are we going to be able to make up a lot of this money? Is this presenting the United States with a kind of bleak fiscal future?

SOROS: No, yes. You see, we have gotten into the habit of consuming 6 to 7 percent more than we are producing. And that game is finished. That was part of the bubble. It was one, globalization.

America, as the center of the globalized financial markets, was sucking up the savings of the world. You know, China was buying government bonds.

And this is now over. The game is out. So, it does mean a very serious adjustment …

ZAKARIA: We’ll have to …

SOROS: … for America.

ZAKARIA: Which means we’ll have to save more.

SOROS: Yes.

ZAKARIA: We’ll have to live within our means and …

SOROS: Yes, yes. Yes, we have been using houses as a piggybank, taking equity out of the mortgages. And that’s what we used for savings – instead of savings.

ZAKARIA: What was fueling this bubble?

SOROS: Every bubble has two components: something – some real trend, and a misconception about that trend.

Now, the real trend has been credit expansion, ever-increasing use of leverage. And the misconception has been what I call market fundamentalism, the belief that markets correct their own excesses, that you can leave it to the markets, give them free rein.

But it really started with President Reagan, who talked about the magic of the marketplace, Margaret Thatcher. You see, when they came to power in 1980, then this belief became the dominant creed. And this, then, led to the globalization of markets, the deregulation of markets and the increased use of leverage and all those financial engineering.

Now, since markets don’t tend towards equilibrium, but are – left to their own devices, go to extremes and create bubbles. And then the bubbles burst.

We have had a number of financial crises since 1980, and quite a few of them. But each time the authorities intervened, and, you know, merged away the failing institution, stimulated the economy if necessary, lowered interest rates, fiscal stimulus, and so on.

And so, the crises, the previous crises actually reinforced the mistaken belief that markets correct their own excesses.

ZAKARIA: And why isn’t it working this time? Because they’re trying to do all those things.

SOROS: Because they’ve reached the end. In the end, bubbles – if the bubbles contain a misconception, as they always do, then it can’t be maintained forever. You know, you can grow a very long way, but, in the end, reality rears its ugly head. And that’s what happened now.

So, the housing bubble acted as a detonator that exploded the super bubble. So it was like in a, you know, an atomic bomb. You have a small explosion that creates a big explosion. So we had the small explosion in the subprime.

And if you recall, Bernanke at the time said, well, that’s a $100 billion hit. We can easily absorb it. But it now turned into what, a $2 trillion hit, because all – one thing after another, because this whole, enormous construct is built on false conception.

It seems, of course, unbelievable. How can such a powerful machine run on false premises?

But that’s what distinguishes social constructs from mechanical constructs. If a car is, you know, designed badly, it just won’t get you there. But badly designed institutions do actually exist.

ZAKARIA: As long as everybody believes in them.

SOROS: Every …

ZAKARIA: It’s all based on trust.

SOROS: That’s right.

ZAKARIA: Is it also going to overshoot on the downside and just in the way that it overshot on the upside? And are we now in that phase?

SOROS: Well, you see, the credit markets have been in distress now for quite some time. The stock market finally is catching up and is now in a sort of capitulation phase now, in the last few days.

ZAKARIA: Do you see a bottom?

SOROS: Well, of course, there will be a bottom. But, you know, one of the things that my theory says, that you can’t actually predict the future, because the future depends on the decisions that people take, what all the authorities react, and so on.

So, while you can predict a trend, and you can predict that the bubble is eventually going to burst, you can’t tell when. And that’s how, for instance, I thought that in ’98 already, it would come to some kind of a climax. And I was wrong.

ZAKARIA: We’ll be right back with George Soros.

(COMMERCIAL BREAK)

ZAKARIA: And we’re back with George Soros.

Tell me what it is that you think should be done, because I’ve been reading you. You wanted a different kind of plan than Paulson’s plan. But it appears that what is being done now is much closer to what you wanted. That is to say, the banks are being recapitalized, or at least some of them are recapitalized.

SOROS: But they are not yet. You see, what has happened is that – I said that the Paulson plan was ill-conceived. It was basically the same kind of financial engineering that got us into the trouble that they wanted to use for getting us out of it. And it was just the wrong thing.

And it’s very – would have been very harmful to waste – I mean, unfortunately, he has been behind the curve all the way, and still is. And that’s why …

ZAKARIA: Paulson.

SOROS: … the market is now collapsing. He just is not able to sort of come to terms to what needs to be done.

ZAKARIA: Why do you think that is?

SOROS: Because I think that he has bought into this market fundamentalist ideology. He did not want to dilute the shareholders, which is what is necessary at the present time.

ZAKARIA: Do you think not bailing out Lehman was a mistake?

SOROS: Yes. That’s what actually kind of unleashed the current phase of meltdown.

And unfortunately, the authorities have lost control of the situation. And that’s why the markets are behaving this way.

ZAKARIA: But now, aren’t they – Paulson has announced that they’ll recapitalize the banks and …

SOROS: No, they haven’t. He has not announced. And it’s very important how it’s done. I think it could be done, this $700 billion could work. Although you also have to do something to stabilize the housing market.

ZAKARIA: Right. But first let’s talk about the recapitalization.

What do you want that’s different from what he said this week?

SOROS: It needs to be done properly. And in this way, I think he could certainly – I would be, for one, would be very interested in buying into some banks at distress price, and others would, too. So actually, you could mobilize private capital. You would then replenish the banks.

Then you would say, for the time being, we lift the minimum reserve requirements. You don’t need to have eight percent; you only need to have six percent. So you can increase your balance sheet, then the banks would start competing for loans. It would turn everything around.

But as I say, the other element that needs to be dealt with is the …

ZAKARIA: The housing.

SOROS: … stabilizing the housing market.

ZAKARIA: OK. So, let’s talk about the other element, which is stabilizing housing, because it is housing that is …

SOROS: Absolutely.

ZAKARIA: … the underlying asset that keeps going down.

SOROS: Yes. If you – and it is liable to overshoot. So, what you need to do – you can’t help the market’s going down when it’s above sustainable levels.

So, it’s not a question of stopping the market from going down, but stopping an overshoot.

ZAKARIA: So, how would you do that?

SOROS: Basically, the important thing is to reduce the number of foreclosures, because foreclosures are putting extra pressure on. Which means that the mortgages have to be renegotiated, and a new form of mortgage issued, which is a sounder mortgage than the current one, to replace it, which the householder could afford to pay and would not exceed the estimated value of the house. In fact, let’s say it would not exceed 85 percent of the estimated value of the house.

And the rest would – the loss would be absorbed by the mortgage owner. But the loss is less that way than the losses that they are going to suffer if the house goes to foreclosure.

ZAKARIA: But, so, what you would do would effectively renegotiate all these mortgages, so that people are not foreclosed on …

SOROS: That’s right.

ZAKARIA: … in some way or the other.

SOROS: That’s right.

Now, they will stay in their houses. That would reduce the supply. And since – and then, mortgages would be available at the advantageous –
basically at an interest rate based on the government bond market, because it would be guaranteed by the government up to 85 percent of the value of the house.

So, people would then, who are currently renting, would want to buy.

ZAKARIA: And this is good social policy also, in a sense, because keeping people in houses …

SOROS: Yes.

ZAKARIA: … is good for the neighborhood. You evict somebody from a house …

SOROS: Absolutely.

ZAKARIA: … the value of every house in the neighborhood would go …

SOROS: It reduces – it reduces the social damage, and it just – it would stabilize the whole situation.

It would, of course, result in losses, which would be then made up for by the recapitalization of the banks, so that you have a banking system that can finance business.

So, this way you would – with some loss, of course – re- establish. And you would have a short recession, not a long one.

ZAKARIA: George, you are in an unusual position. You have been a skeptic or a critic of this new globalized world of finance, of the deregulation, of the enormous fluidity of capital markets – but you have massively benefited from it. You have been able to play the game that you play in the hedge fund space, precisely because of all these forces.

So, is it a good thing, or is it a bad thing?

SOROS: Well, there is no contradiction, because I think I understand how it works, and I understand its flaws. And so, I seem to be reasonably successful as an investor.

But as a citizen, of course, I would like – first of all, I would like the market mechanism to work better. It’s much better than government controls.

So, I’m a believer in the market system. But I also recognize that the market system is flawed, because all human constructs are flawed, and we need to improve them. And I hope to see it improved.

ZAKARIA: But government then would also be flawed. I mean …

SOROS: Well, of course, government is – I mean, this is the important thing to learn. I mean, this is what my book tries to explain, that it is the human condition that perfection is unattainable. And just because, let’s say, socialism has failed and government controls are inefficient doesn’t make markets perfect.

Markets are also imperfect. So you do need regulation, knowing that the regulators are also human.

And what is worse, they are bureaucratic and they are subject to political influences, so you want to rely on them as little as possible. So, you want as little regulation as possible, but you want better regulation.

ZAKARIA: We’ll be right back with George Soros.

(COMMERCIAL BREAK)

ZAKARIA: You’ve been an early supporter of Obama.

SOROS: Yes.

ZAKARIA: Do you think that he would handle this better?

SOROS: Yes.

ZAKARIA: Who would be secretary of Treasury if you had to pick?

SOROS: Well, I don’t know if should answer that question.

ZAKARIA: Would you serve if you were asked?

SOROS: No. I’m a little bit old. I would certainly be available with advice. I’m even available to this government with advice. But I’m not going to …

ZAKARIA: Speculate.

SOROS: No, no. I mean …

ZAKARIA: People say that you fund the Democratic Party. You’ve seen the – when you see things like the Saturday Night Live skit, what does it make you think?

SOROS: Well, it was very flattering, of course.

(BEGIN VIDEO CLIP FROM SATURDAY NIGHT LIVE SKIT)

WILL FORTE AS GEORGE SOROS: So, what became of that $700 billion? Well, basically it belongs to me now.

(LAUGHTER)

Actually, it’s not even dollars anymore, but Swiss francs, since I have taken a short position against the dollar.

JASON SUDEIKIS AS PRESIDENT GEORGE W. BUSH: Oh, really? That’s not good.

FORTE: You’re not to speak. I don’t like you.

(LAUGHTER)

Yes, the U.S. dollar will have to be devalued sometime next week, either Tuesday or Wednesday. I haven’t decided which yet. It will depend on how I feel.

FRED ARMISEN AS REP. BARNEY FRANK: Thank you very much, Mr. Soros. You’re a great man.

FORTE: Yes. Could I just add that, even though you know what’s coming, you won’t be able to do anything about it.

ZAKARIA: Do you think that you have – that rich people have undue influence in politics in America?

SOROS: Yes. Yes.

ZAKARIA: But given the rules, you’re not going to back out.

SOROS: No. I mean, there are other rich people who have influence. I don’t – I try not to abuse – I mean, I don’t think that I misuse my money.

I don’t use my money to gain political influence for my private interests, which is what many rich people do, and what, in a sense, market fundamentalism does, because it is in the interests of people who have a lot of money to have as little taxes as possible.

I actually believe that there is a need for taxation, that this anti-taxation position is actually false, because the government is supposed to provide services, and those services cost money. And somebody has to pay for it.

ZAKARIA: Tell me what you think the geopolitical or geoeconomic effects of this financial crisis are.

Are we witnessing the kind of de-Americanization of the global financial system? In other words, are countries going to not rely on America as the center of finance?

I ask this, because one of the puzzling moves over the last few weeks has been, with all these calamities in the United States, the dollar keeps strengthening.

SOROS: Yes.

ZAKARIA: Because in a strange way, there’s a flight to safety. And the only thing people trust is the dollar.

SOROS: No, there’s a technical reason. There’s a shortage of dollars, and the dollar has been oversold.

ZAKARIA: So, in the medium term, you suspect the dollar will decline and America’s central role will decline.

SOROS: I think that, in many ways, this brings home the decline in America’s position in the world, because we have over-consumed. The Chinese have produced a lot more than they consume, so they built up reserves. We built up debts; they built up assets.

And the same applies to the oil-producing countries. So, there’s been a tremendous power shift.

ZAKARIA: Do you think this power shift is permanent?

SOROS: America will still be a leader – if not the leader – of the world. And in fact, if America uses its position to cooperate with other countries, it can reemerge as the leader, and the world very much needs that kind of leadership.

ZAKARIA: George Soros, a pleasure to have you on. The book is fascinating. Thank you.

SOROS: A pleasure.

ZAKARIA: And we’ll be back.

(COMMERCIAL BREAK)

ZAKARIA: What I want to discuss now is what this economic crisis, this financial crisis does to the United States, how we got here, what are we going to do going forward – step back a little bit.

And to join me, a distinguished panel of economic observers: the “Washington Post” columnist, Sebastian Mallaby, who is also at the Council on Foreign Relations; Jeffrey Sachs of Columbia University and the U.N. and many other things; and from Washington, Fred Bergsten, the director of the Peterson Institute of International Economics.

It is likely that the budget deficit would be $1 trillion. If this financial crisis plays out and the federal government has to assume all these liabilities, engage in some kind of stimulus spending, is that really the kind of numbers we are likely, probably likely to see?

FRED BERGSTEN, DIRECTOR, PETERSON INSTITUTE FOR INTERNATIONAL ECONOMICS: Yes. I think the budget deficit could go to at least $1 trillion in the next year or two. Partly that’s because, when the economy slows down, receipts from taxes always decline. But it’s because we already are looking at something on the order of $500 or $600 billion before this crisis.

The costs of addressing the crisis itself – the support for the banks and other financial institutions – will be in the tune of several hundred billion dollars, depending how it’s accounted. It could be even more than that in the short run.

And then, I think the new administration, as its first initiative, will probably undertake an economic stimulus program to try to get the economy jumpstarted. That will be more tax cuts. It’ll probably be extensions of unemployment insurance and some infrastructure investments. It may be some block grants to states, because they’re having financial troubles.

All that will add up to another several hundred billion dollars. So, the budget deficit almost certainly will hit $1 trillion or more in the first year of the new administration, among other things, putting a severe constraint on what it can do in other areas.

ZAKARIA: But Sebastian, we were supposed to make money off this bailout. I thought the whole idea was the Fed is buying assets that are cheap, because everyone is scared – I mean the Treasury. And they’ll be able to hold them and sell them off at a profit.

SEBASTIAN MALLABY, “WASHINGTON POST” COLUMNIST AND DIRECTOR, MAURICE R. GREENBERG CENTER FOR GEOECONOMIC STUDIES, COUNCIL ON FOREIGN RELATIONS: We’ve gone beyond simply a problem that reflects, you know, a busted property market, the fact that banks have holes on their books. We’ve even gone beyond the effects of deleveraging, which were bound to be inescapable. We’ve got into a complete, blind panic of confidence thing, where no one will lend to anybody.

So, I do think that asset prices, on some measures, are incredibly depressed. So, if the government buys a lot of assets now as part of this bailout strategy, either by buying assets from banks on their –
their deliverance (ph) – or by injecting some form of equity into them, it could be that they would have holdings that, in the end, they could sell later at a higher value.

ZAKARIA: But in a way …

BERGSTEN: But Fareed, Fareed …

ZAKARIA: Yes. BERGSTEN: … just to be clear, though, I was clear and said, in the short run there will be a big budget cost. The government may be able to make money on the loans or recoup most of its investment later on, but that’ll be several years down the road.

In the short run, there will be a cash flow cost. It’s not clear how it’ll be counted for the budget. But in the short run, the government will have to put a lot of money into this operation.

ZAKARIA: Well, and also, it sounds like a lot of this money is not just buying assets. It’s block grants to states. It’s the reality of reduced tax revenues.

So, it sounds like we are facing a very diminished fiscal environment –
in other words, a very constrained president, who is not going to have a lot of money to spend things on.

BERGSTEN: There’s no doubt about that.

ZAKARIA: Jeff?

JEFFREY SACHS, DIRECTOR, COLUMBIA UNIVERSITY’S EARTH INSTITUTE: I think the direction is right. Whether we reach $1 trillion is a matter of choice, not a matter of inevitability.

I do think the era of big tax cuts, whether for stimulus or other things, are over. We’re going to have to grow up and understand that we need taxes to pay for basic government services. We’ve been neglecting that for a long time.

We’re going to have to come back to reality. We’ve been in fiscal unreality even before the crisis. Now the crisis is going to make all of this more dramatic. We’ll have large budget deficits, as Fred and Sebastian have said.

The scope for big tax-cutting – the McCain ideas are absolutely surrealistic. They are completely outside of anything sensible.

Rich people are going to have to pay taxes again. That’s just going to be part of America once again.

ZAKARIA: And what does it mean, Jeff, in terms of the various programs that the candidates have suggested?

Obama has talked about alternate energy, massive investment there. McCain, as you said, has talked about tax cuts.

Is that really all? I mean, is any of that possible?

SACHS: It’s got to be possible, because those are crucial things for our future.

SACHS: We’ve been trying to run a government on about 17 percent of national income in taxation ever since the Reagan era came in. It’s been a myth all the way along. We’ve been borrowing heavy amounts all through the period.

You can’t squeeze government when you take into account Social Security and Medicare, Medicaid, military, the interest on the debt – things that have to be done. When you see all the other things that we care about, the quality of our lives, all squeezed into a tiny little amount, which is what’s happened for almost 30 years now, we’ve run out of that game.

So, this is not only a financial crisis, it’s the end of the Reagan era. It’s time to grow up again and understand that we’re going to have to pay taxes – rich people first – and that from there, we’re going to have to use those revenues for the things that count: health, education, infrastructure, energy.

This is not an invitation to ignore our future. It’s an invitation to start thinking seriously about it again.

BERGSTEN: The other element to add to the unsustainability of our current situation is that the foreigners have actually been paying, at the margin, most of the increase in our national borrowing. We’ve been borrowing half-a-trillion dollars or more per year from the rest of the world for the last five to 10 years.

That means the United States is now the world’s largest debtor country.

Part of the pressure on the government here and the Federal Reserve to deal with our financial crisis has been the fear that our foreign creditors would bail out of the dollar, start dumping dollars. Fortunately, they have not done that. I think that can be avoided. But we have to retain their confidence even more than we have to retain confidence at home, because we put ourselves in the position of being in hock to the world.

That can’t go on. We can’t increase that further. We can’t put ourselves more in debt to the rest of the world and lose control over our own destiny.

So, for that reason, as well, we’ve got to get real, as Jeff said, get our house in order. That’s what it boils down to.

SACHS: Fred, I just wonder, because this will be a question facing the new president quite urgently. As much as I’d love to agree with you, and almost always do, a $1 trillion deficit is actually not going to be very much of a boost of confidence. And I am not so sure, in the kind of environment that we’re in right now, that that’s so easy to finance from external flows anymore, also.

ZAKARIA: So you’re saying, no tax cuts. SACHS: You know, look, I’m the only one saying it, because everyone wants it, and everyone loves it. But, you know, if it’s really a budget deficit at $800 billion or $1 trillion, and we’re sitting there asking, OK, now another big tax cut on top of it, is that really going to be realistic?

Painful as it is to say, because no one wants to hear that, so it’s not …

ZAKARIA: Sebastian, where do you come down on this?

MALLABY: Well, I think we’re caught between two distinct problems on the external financing side. On the one hand …

ZAKARIA: External financing, just to explain, is we go out to the market, the United States government, and ask foreigners to buy about $4 billion of IOUs every day.

MALLABY: Right. And the point here is that it’s foreigners buying these assets. And so, if they don’t have faith in the credibility of American Treasury bonds or other financial assets – because a lot of the financing that went on, it was foreigners not buying American government debt, it was private debt. It was debt issued by Wall Street on behalf of companies, and so forth, including a lot of securitized mortgage assets.

And so, the argument in the past has been, look, foreigners buy this stuff, because they believe in the institutions on Wall Street. They believe in the credibility of American financial regulation. Now that that credibility has been shot in half, the question is: Will the foreigners continue to finance American borrowing needs?

And when you rely on governments, who have made a political decision to lend America money, those same governments could make a new political decision to stop lending America money.

So, without really realizing it, we’ve gotten ourselves into a position where we have a foreign policy liability. If China, which holds a lot of American debt, decided to sell it or to switch the debt into some other dollar instrument – for example, the equity market – it could disrupt our capital market, inflict a lot of pain on us.

And in a sort of extreme scenario, like a Taiwan crisis, or something like that, I think this becomes a foreign policy tool that we haven’t begun to reckon with yet.

ZAKARIA: We’re going to get right back, and we’re going to talk about the effects all this has on the real economy, when we come back.

(COMMERCIAL BREAK)

ZAKARIA: And we’re back with Jeff Sachs, Sebastian Mallaby, and Fred Bergsten in Washington.

Fred, the most puzzling statistic in the midst of all this financial mess is the real economy, which does not seem to be as affected as you would think it would be. You know, unemployment is rising, but it’s still, what, 6.5 percent, or something like that. If you look at really bad recessions in the past, it’s been much higher.

Are we measuring all this stuff right? Or is this financial crisis not having as much of an effect on the real economy?

BERGSTEN: I think we’re measuring things basically correctly. The issue is whether the crisis, the financial crisis, will now all of a sudden tank the real economy.

In the second quarter – the last full period for which we have data –
the U.S. was still growing at close to 3 percent. Now, that was for a simple reason: the rest of the world was still growing. So, the real risk to the U.S. economy now is a sharp turndown in the rest of the world economy – Europe, Japan, Canada, and particularly the emerging markets.

It’s the emerging markets – China, India, Korea, Brazil and the like –
who now make up half the world economy, when exchange rates are calculated for that purpose.

ZAKARIA: Sebastian, what is this world going to look like? Because right now, it appears that the Federal Reserve and the U.S. government is essentially insuring – “backstopping,” as they call it – every kind of debt, because nobody is willing to invest in anything that does not have the full backing of the United States government.

So, we end up in a situation where the United States government is now, without question, the largest bank in the United States. It’s probably the largest bank in the world.

We’ve nationalized the banking system in this country. Right?

MALLABY: That’s right. I mean, in the past in the interbank market, banks lent to each other, and bank A would lend to bank B. Now, bank A is too frightened that bank B is not sound, and so it won’t lend. So instead, bank A lends to the U.S. government, and the U.S. government lends to bank B.

And this is something which has been happening bit by bit over the past months, and is now about to happen a lot more, because confidence has totally dried up.

SACHS: The Fed made a bad mistake. It’s done a reasonably good job at many points, though it made the biggest mistake of watching as this thing, the bubble, expanded till it burst.

But it made a bad mistake in how it handled the Lehman closure. This will, in retrospect, be the biggest tactical blunder that they made in this crisis.

ZAKARIA: They shouldn’t have let it go under.

SACHS: Even if they had let Lehman go under, they could have protected the short-term money market paper, which they didn’t do. In other words, the shareholders could have lost – the owners of longer term debt to Lehman could have lost. But by letting the short- term paper go bad, that broke the money markets, and that created the panic. And that was a tactical blunder of tremendous significance.

Since then, they’ve been scrambling with everything they can think of, lending in every which way. The bailout plan emerged two days after the Lehman mistake. And so, they’re trying still to calm what is now an outright panic.

I think it’s possible to do. And I do think they will end up calming this panic.

That won’t stop a recession. It won’t solve the bank recapitalization problem. It won’t solve the problem of households that are at the limit of debt and can’t repay their mortgages.

So, the structural imbalances are real, and will mean that the U.S. economy goes through a significant recession and a lot of pain as it restructures. But what is most important right now is to stop the panic, because that’s seizing up day-to-day economic operations.

MALLABY: You know, but there’s a big issue, as well, which goes beyond this immediate stuff, which is that the role of government – not just in this interbank lending, short-term lending – is growing. It’s also that the role of the state generally in the economy has been growing, with huge accumulations of capital in the hands of governments around the world, notably in East Asia and the energy- exporting states.

ZAKARIA: So ((inaudible)) Singapore, Abu Dhabi, Saudi Arabia …

MALLABY: Right.

ZAKARIA: … even Russia.

MALLABY: Exactly. In sovereign wealth funds partly. Also, just in central bank reserves, which have grown and grown and grown. State-owned companies, particularly in the energy sector, becoming a bigger and bigger influence.

And so, I think the premise of globalization, which is essentially that it has been a non-government, sort of pro-market project and, therefore, acceptable, because when we traded with foreigners, these foreigners had the same incentives as we did, which was basically to make profits, do better for their families and live by the same sort of metrics that we understand for human motivation.

If it’s government that gets involved in the allocation of money and goods, and so forth, then there can be a political agenda attached to flows of goods or flows of money. And then I think it becomes a bigger foreign policy question.

ZAKARIA: Jeff, you have the last word. When you were a very young economist, you went around the world dealing with small countries that had gotten themselves into a complete fiscal mess, like Bolivia. And then you went to Poland and Russia, and places like that.

Looking at all these crises in the past, is this much bigger? And, you know, what’s the historical perspective here?

SACHS: This is not as devastating as some of those were for those countries. But in absolute size, because of the state of the U.S. as being the world’s biggest economy, this, of course, dwarfs all of those crises. This is our biggest crisis in half a century.

What I said to those countries is, you have to get your budget house in order. And that’s the same for us.

McCain is going to lose, because he stands for a philosophy that is broken and that has brought this country down to its economic knees. That’s why he’s losing, because the age of Reaganism is over. The no regulation, low taxes has broken the back of our economy.

Now, we have to again get serious about reconstructing normal government that pays its way and a normal financial sector that’s properly regulated.

That’s why Senator Obama is going to be the next president.

ZAKARIA: On that note, Jeff Sachs, Sebastian Mallaby, Fred Bergsten, I thank you all very much.

And we’ll be back.

(COMMERCIAL BREAK)

ZAKARIA: Forty-six years ago this week, the world came as close as it ever has to nuclear war. On October 16, 1962, President John Kennedy convened an executive committee to advise him on what was later called the Cuban Missile Crisis.

On Sunday, October 28th, the crisis officially ended when President Khrushchev publicly agreed to withdraw Soviet missiles from Cuba. This fortnight of high drama was the climax of the Cold War, and tested American decision-making and leadership.

So, as we approach a presidential election, it is worth thinking about the kind of leadership we need to get through the challenges of the future.

That means recognizing how different today’s world is from 1962. The Cold War is over. The Soviet Union is dead. America’s military is larger than the next 22 countries put together.

The threat we face right now is in the world of geoeconomics, not geopolitics – how to get through this financial meltdown, how to handle the multiple economic challenges before us, how to steer America in a world where other countries are gaining power and resources and confidence.

Senator Kennedy was a young man, untested in any high office, and the first president who was not a white Anglo-Saxon Protestant. Yet he was the right man for the times.

Why? He had a calm temperament, he assembled a group of wise men to advise him – some of them Republicans – and he thought creatively about the problem. He found a way to preserve American interests in the Cuban Missile Crisis without provoking a Soviet military response.

Today’s challenges are very different, but the kinds of qualities a good leader should have remain the same: intelligence, patience, creativity and calm.

That’s it for this week.

Before I go, I want to thank you for all your e-mails. Last week I asked you who you thought was the least qualified vice president the United States has ever had. The results are in.

Spiro Agnew got a lot of votes. So did Dan Quayle. And Aaron Burr was a frontrunner, because, as one viewer pointed out, “He shot somebody.”

But it was another vice president, who also shot somebody, who won our highly unscientific poll. Dick Cheney got the most votes.

Now, my question for you for this week is: What country do you think will emerge most unscathed from this global financial crisis? Who will come out best?

Also, I want to recommend a book. I was just telling you that this is the anniversary of the Cuban Missile Crisis, and I’ve been reading “One Minute to Midnight,” by Michael Dobbs. It’s a gripping, moment-by-moment account of the crisis, the best one I’ve read. I think you’ll enjoy it.

Remember, you can e-mail me at fareedzakariagps@cnn.com. You can also visit our Web site, cnn.com/gps, for highlights from this program. And you can always find our weekly podcast on the Web site and on iTunes.